Marvin Appel, MD, PhD, and Brian Hufford, CPA
If you need income from your investments but cannot afford to take much risk, you might feel that you are in a bind. With interest rates near their lowest levels in 50 years, money market returns are not even keeping up with inflation. Yet, if you commit to longer-term bond investments for greater yield, you expose yourself to the risk of locking in low rates of return when better opportunities may lie ahead if you can afford to be patient. There is a potential solution to this dilemma — our topic this month.
Interest rate outlook — From March through mid-May, long-term interest rates jumped sharply higher. For example, the yield on the 10-year Treasury Note rose from 3.7% to 4.9% in under two months. If you held 10-year Treasury Notes in your portfolio, their value fell 8%, erasing almost two years' worth of interest payments.
The factors that helped push long-term interest rates higher remain: government deficit spending, weaker U.S. dollar, rising energy and commodity prices, rapid economic growth, improving job market. In fact, the Federal Reserve is poised to raise short-term rates to allay the fears of inflation that drove long-term rates up in the first place. (The Federal Reserve has a high degree of control over short-term interest rates — those that apply to loans of two years or less — but not over the rates that apply to longer-term lending.)
The good news for those invested in bonds, either directly or through mutual funds, is that we do not foresee another big jump in long-term interest rates this year. Historically, the bond market has tended to stabilize for up to six months following the kind of upheaval we experienced from March to May.
Even so, the long-term outlook remains clouded. Interest rates and inflation still lie near 40-year lows, which gives them far more room to increase than to decrease. To avoid another debacle such as befell bondholders from March through May, you can use the investments described below to get higher yields without suffering if interest rates should resume their rise.
Stable value funds — You can insure almost anything, so why not your investments? Certain bond mutual funds have insured their share price with insurance companies. Fund holders collect the interest from the underlying portfolio (less the premiums paid for the insurance), while the insurers bear the risk. So if you buy a stable value fund and interest rates happen to increase, the insurance company must make good on the fund's capital losses while you, the shareholder, benefit from an increase in yield. This is, however, a two-way street. If you buy a stable value fund and interest rates decline, the insurance companies reap the capital gains while your interest return decreases.
These funds have been among the best-performing investments in terms of reward relative to risk. There are two main drawbacks. First, the funds are not always open to new investors. Second, stable value funds are available only to tax-deferred accounts, either through IRAs, retirement plans, or variable annuities. Also, all of these funds have redemption restrictions that you need to consider carefully before committing your capital.
The funds we recommend for IRA accounts are Scudder Preservation Plus (DBPIX), currently yielding 4.3%, or PBHG IRA Capital Preservation Fund (PBCPX), currently yielding 2.8%. The Scudder fund is currently closed, while the PBHG fund is open. Retirement plans such as the 401k should consider First American Stable Asset Advisor Fund (FSAAX) which currently yields 3% and is open to new investors.
Short-term bond funds — Investors looking to invest non-retirement assets in a safe manner should consider the Vanguard Short Term Corporate Bond Fund (VFSTX—currently yielding 3%) or the Vanguard Short Term Tax-Exempt (VWSTX, current yield 1.7%). Among short term bond funds, these Vanguard offerings stand out because of their rock-bottom expense ratios (0.2% for the corporate bond fund, 0.17% for the municipal bond fund) and long performance histories.
Conclusion — Stable value funds and short-term bond funds offer two potential solutions for conservative investors who need greater returns than they can get from money markets. Investors should utilize these vehicles while they wait for higher interest rates, which may come our way in 2005.
Dr. Marvin Appel is CEO of Appel Asset Management. He holds a degree in biochemical sciences from Harvard College and earned his MD in 1991. He is coauthor of Systems and Forecasts. Contact him at (516) 487-7146 or email@example.com. Brian C. Hufford, CPA, CFP, is president of Hufford Investment Advisory Programs, LLC, and Hufford Financial Advisors, companies dedicated solely to helping dentists secure solid financial planning and safe investment strategies. He can be reached at (317) 848-4987.